Week 11: Assignment 11: Solution
Q1. An increase in interest rates causes the opportunity cost of holding money to ________
and the money demand ________.
A. rise; rises
B. rise; falls
C. fall; rises
D. fall; falls
Answer: B. rise; falls
Explanation: When interest rates increase, the opportunity cost of holding money rises
because by holding onto money, you are forgoing the interest you could have earned by
putting that money in an interest-bearing account or investment. As a result, people tend to
hold less money, and the demand for money falls when interest rates increase.
Q2. To attain the money market equilibrium, at _______ levels of income, _______ interest
rates are required, that is why LM schedule slopes upwards.
A. higher; lower
B. lower; lower
C. lower; higher
D. higher; higher
Answer: D. higher; higher
Explanation: At higher levels of income, higher interest rates are required to attain money
market equilibrium. This is because as income increases, the demand for money (to transact
for higher levels of economic activity) also increases, which, in turn, requires higher interest
rates to maintain equilibrium in the money market.
Q3. Let the income-induced money demand be 0.3 and interest elasticity of money demand
be 0.2, and the slope of the LM curve is
A. 0.06
B. 0.1
C. 1.5
D. 0.5
Answer: C. 1.5
Explanation: Slope of LM curve = income induced money demand/ interest elasticity of
money demand = 0.3/0.2= 1.5
Q4. When the interest elasticity is high, a ______ rise in rate of interest is required to restore
equilibrium in the money market. Similarly, When the interest elasticity is low, a ______ rise
in rate of interest is required to restore equilibrium in the money market.
A. small; small
B. small; large
C. large; small
D. large; large
Answer: B. small; large
Explanation: When the interest elasticity of money demand is high, it means that a small
change in the interest rate will lead to a relatively large change in the quantity of money
demanded. In this case, a small rise in the interest rate is required to restore equilibrium in the
money market. Conversely, when the interest elasticity is low, it means that a relatively large
change in the interest rate is needed to induce a small change in the quantity of money
demanded. In this case, a large rise in the interest rate is required to restore equilibrium in the
money market.
Q5. Consider an IS-LM framework, If the RBI conducts open market ________, the money
supply ________, shifting the LM curve to the left and _______ the interest rate, everything
else held constant.
A. purchases; decreases, increasing
B. sales; decreases, increasing
C. purchases; increases, decreasing
D. sales; increases, decreasing
Answer: B. sales; decreases, increasing
Explanation: When the RBI conducts open market sales, it means they are selling
government securities to the public or financial institutions. By selling these securities, the
central bank takes money out of the hands of individuals or banks who purchase these
securities. This action reduces the amount of money in circulation in the economy. With less
money in circulation, the overall money supply in the economy decreases. When the money
supply decreases, this shifts the LM curve to the left. As the LM curve shifts to the left, it
means that at any given level of income, the interest rate is now higher. This is because with a
reduced money supply, borrowers must compete for the available funds, which drives up the
cost of borrowing. Therefore, interest rates increase.
Q6. When the money supply increases, for the given level of income, demand more bond
______. As a result, the price of bond ________ and the rate of interest ______.
A. decreases; decreases; increases
B. increases; decreases; increases
C. increases; increases; decreases
D. increases; increases; increases
Answer: C. increases; increases; decreases
Explanation: When the money supply increases, it prompts individuals and investors to seek
out more bonds as an alternative investment to hold the surplus funds. This higher demand
for bonds naturally drives up their prices because there is increased competition to purchase
them. However, there's an inverse relationship between bond prices and bond yields, which
are essentially interest rates. When the prices of bonds rise due to increased demand, their
yields, or the returns they offer, decrease.
Q7. Let The MPC = 0.8, It is known that the GDP has increased by $5 million, what is the
change in government expenditure? (Consider a Simple Keynesian Model)
A. $6.25 Million
B. $1 Million
C. $4 Million
D. $400,000
Answer: B. $1 Million
Explanation: Multiplier = 1 / (1 - MPC) = 1 / (1 - 0.8) = 1 / 0.2 = 5
ΔG = (Change in GDP) / Multiplier = $5 million / 5 = $1 million
Q8. Calculate the slope of IS curve if the Marginal Propensity to consume is 0.8 and the
Interest Elasticity of Investment is 0.2.
A. 1
B. -1
C. 4
D. -4
Answer: B. -1
Explanation: Slope of IS curve = -(1-MPC)/interest elasticity of investment = -(1-0.8)/02=-1
Q9. An increase in autonomous Government expenditure causes a ________ in the ______
curve, everything else is held constant.
A. rightward; LM
B. rightward; IS
C. leftward; IS
D. leftward; LM
Answer: B. rightward; IS
Explanation: The IS curve represents the relationship between interest rates and the level of
income or output where the goods market is in equilibrium. An increase in government
expenditure would lead to higher aggregate demand, shifting the IS curve to the right, as
higher government spending stimulates economic activity and increases income.
Q10. Equation of IS curve is given by Y =2300-50r, Equation of LM curve is given by
Y=600+100r. Calculate equilibrium Y and r
A. 1733, 11.33
B. 2300,17
C. 1600, 10
D. 2400, 18
Answer: A. 1733, 11.33
Explanation: The equilibrium occurs when the goods market (IS) and money market (LM)
are both in balance.
2300 - 50r = 600 + 100r
r = -1700 / -150 = 11.33
Using LM curve equation, Y = 600 + 100r = 600 + 100 * 11.33 = 600 + 1133 = 1733
